Federal Reserve Bank of Chicago Bank Structure Conference May, Armen Hovakimian, Baruch College Edward J. Kane, Boston College Luc Laeven, IMF

Transcription

1 Federal Reserve Bank of Chicago Bank Structure Conference May, 212 Armen Hovakimian, Baruch College Edward J. Kane, Boston College Luc Laeven, IMF

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3 When it comes to haircutting creditors and counterparties in firms like AIG, I wish our Regulators had the Courage of our Monster Banks 3

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5 We contend that macroprudential risk comes from a combination of industry risk-taking and authorities selective exercise of a Rescue Option and that the rescue option shifts considerable risk to taxpayers and small banks. Large banking organizations turn this option into a conditioned Reflex by finding ways to make themselves harder and scarier for authorities to fail and unwind. They do this by increasing their size, complexity, leverage, and/or maturity mismatch. The FDIC is accountable for Microprudential Risk. But Safety nets subsidize systemic risk creation in good times partly because the accounting frameworks used by banks and government officials do not make anyone directly accountable for reporting or controlling safety-net subsidies until and unless markets sour. 5

6 The per-period flow of safety-net benefits that a particular bank enjoys can be defined as a fair annual insurance premium percentage (IPP) expressed per dollar of the institution s debt. We interpret a firm s systemic risk as the value of its option to put potentially ruinous losses and loss exposures to taxpayers. Its managers ability to trigger forbearance for capital shortages and stand-alone tail-risk (i.e., losses that exceed taxpayers value-at-risk supervisory protection) increases the value of the safety-net benefits it receives. This creates an incentive for managers to search out, to lobby for, and to exploit weaknesses (i.e., loopholes) in risk-control arrangements.

7 Treasury Efforts to Convince the Public that Ex Post the Heavily Subsidized TARP and Fed Rescue Programs Made Money Dishonor Government Service and Disgrace the Economics Profession. Bailout deals left taxpayer money on the table that should in principle be acknowledged and defended. Our opportunity-cost methods for measuring systemic risk help to assess how large the subsidies were. All US and EU safety nets include implicit and explicit guarantees for bank creditors whose opportunity-cost value grows with a bank s size complexity and political clout. By engaging in cosmetic accounting, undertaking regulation-induced innovation and exerting lobby pressure, important financial firms can and (we find) do keep these guarantees from being fully priced.

8 Edward J. Kane

9 Edward J. Kane

10 Our modeling procedure follows Merton (1) in portraying taxpayer credit support as a one-year European put option on the bank s assets. ). Merton portrays safety-net access as an option that allows bank owners to put the bank to safety-net managers for the face value of the bank s debt. We allow authorities to refuse to exercise taxpayer s side of the put (Kane, 16). As observable input variables, our models use the book value of debt (B), the market value of a bank s or bank holding company s equity (E), the standard deviation of the return on equity (σ E ) and the fraction of bank assets distributed yearly as dividends to stockholders (δ). The synthetic variable IPP expresses the fair annual premium for stand-alone safety-net support per dollar of debt. Merton (1, 1) shows that the IPP increases both with a bank s leverage and with the volatility of its return on assets. In Merton s model, leverage is measured as the ratio of the market value (B) of deposits and other debt to the market value of a bank s assets (V). Volatility is defined as the standard deviation of the return on bank assets (σ V ). 1

11 No reason to expect either disinformational capacity or political clout and (therefore) proportionate Safety-Net Benefits to be the same at all times or at small versus large banks. Unique features of our analysis: We distinguish a bank s stand-alone risk from its systemic risk and we recognize that mischaracterizing insolvency issues as liquidity problems allows a flow of zombieinstitution dividends to continue.

12 We conceive of IPP as the dividend that taxpayers would be paid on their contingent equity stake in a given firm if information asymmetries did not exist. The value of a bank s taxpayer put increases with the extent to which creditors and stockholders are confident that they can scare authorities into shifting ruinous losses to taxpayers without adequate compensation. We develop two different opportunity-cost measures of the costs of taxpayer support: The stand-alone IPP with prompt resolution: the IPD The systemic-risk IPP that incorporates an implicit estimate of likely forbearance: the IPDS.

13 We measure a bank s contribution to systemic risk relative to the IPP that our model implies quarter by quarter for the portfolio of sample banks taken together. A bank s systemic risk (IPDS) is the difference between the IPD that arises for the sectoral portfolio when that particular bank is and is not included. 13

14 Panel A. Top 1 banks Ranked by Stand-Alone Risk # Bank Regulatory or market response 1 1st Pacific Bancorp Shut down 2 Bay National Corp Shut down 3 Pacific State Bancorp/CA Shut down 4 First Bankshares Inc/VA Acquired 5 Community Shores Bank Corp Consent order 6 Crescent Banking Co Shut down Ohio Legacy Corp Consent order Sun American Bancorp Shut down Bank of the Carolinas Consent order 1 Sterling Banks Inc Shut down Panel B. Top 1 banks Ranked by Systemic Risk # Bank Fiscal Quarter Assets ($ million) 1 State Street Corp 2 Q1 142,144 2 Wells Fargo & Co 2 Q1 1,25,1 3 PNC Financial Services Group 2 Q1 26,422 4 Trico Bancshares 2 Q3 1,6 5 Regions Financial Corp 2 Q3 144,22 6 Banctrust Financial Group 2 Q4 2, Marshall & Ilsley Corp 2 Q1 61, Bank of America Corp 2 Q1 2,321,63 Pacwest Bancorp 2 Q4 4,46 1 Frontier Financial Corp 2 Q3 4,245 14

15 Mean Stand-Alone Risk (IPD) at Sampled Banks

16 Using the Dividend-Forbearance Model Introducing a Dividend Stopper

17 1. Bank risk-taking increases in late booms and gets worked down again as economic recovery takes hold. 2. Bank risk-taking increased markedly after the S&L mess. Megabankers recognized how reluctant authorities were to address a pattern of industry insolvency. 3. The Fed s Pre-TARP reluctance to conduct triage and impose immediate dividend stoppers in their 2-2 rescue programs cost taxpayers a lot on average. 1

18 Although Accounting and Tier-1 Capital Ratios were controlled, the Model-Implied ratio of market value capital went down sharply from 26 on. The Lehman-AIG event merely surfaced longstanding weakness. Our straightforward and easy-to-calculate measures could have been used in potentially golden moments to uncover and mitigate the efforts to arbitrage capital requirements. 1

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20 25% Implied Ratio of Capital to Assets at Sampled Institutions 2% 15% 1% 5% %

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22 5 Mean Systemic Risk Premium at Sampled Institutions

23 45 Mean Systemic Risk Premium for Large Banks Only

24 SCAP ($Bil) Other Measures SCAP/Tier1 Capital Acharya et al. MES ($Bil) Value of Stand-alone Support ($MM) Stand-alone Risk Premium IPD (bp) Our Measures Value of Systemic Risk Support ($MM) Systemic Risk Premium IDPS (bp) Bank of America Corp % Wells Fargo & Co % Citigroup Inc % Regions Financial Corp % Suntrust Banks Inc % Keycorp % Morgan Stanley Dean Witter & Co % Fifth Third Bancorp % PNC Financial Services GRP INC.6 2.4% American Express Co.% Bank New York Inc.% JPMorgan Chase & Co.% US Bancorp.% State Street Corp.% BB&T Corp.% Capital One Financial Corp.% Goldman Sachs Group Inc.% Metlife Inc.% Notes: SCAP is the capital shortfall calculated in the supervisory Capital Assessment Program conducted in February 2 and MES is the Marginal Expected Shortfall calculated by Acharya et al. (21) from data in periods during which stock-market returns lie below their fifth percentile. 24

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26 Ever wonder how taxpayers and small banks will pay for megabank rescues? 26